Posts Tagged ‘roll-over IRA’

It’s not very often that the U.S. Supreme Court involves itself in legal issues related to estate planning and elder issues. Last week, though, the Court did just that — by ruling that an inherited IRA is not exempt from the beneficiary/owner’s creditors, at least in a bankruptcy proceeding. What does the decision (in Clark v. Rameker, June 12, 2014) mean for you, and is there any way for you to avoid the result suffered by Heidi Heffron-Clark?

First, let’s figure out how much of a problem the Supreme Court decision creates for you. Let’s suppose that you have diligently contributed to your own IRA, and that you have managed to accumulate a significant sum — just to give it a figure, let’s suppose that your IRA is now worth $300,000. Now suppose that you are involved in an auto accident, and you are sued for injuries caused by the accident. Of course you have auto insurance, and that should take care of most or all of the liability. If your insurance is inadequate, though, can the injured party reach your IRA? The short answer (subject to a handful of exceptions unlikely to apply to you) is an emphatic “No.”

But what if you get divorced — can your soon-to-be-ex-spouse get a share of your IRA? The answer here is generally a qualified “Yes,” but there are specific rules that have to be applied and your actual answer will be very dependent on state law and facts about your marital situation.

One more theoretical question about your theoretical IRA: if you have a series of financial reverses and have to file for bankruptcy, will your IRA be scooped up the bankruptcy court (more accurately, the bankruptcy trustee)? Generally, the answer here is “No.” Your IRA is, in most cases, protected from your creditors — even in bankruptcy.

Does it make a difference if your retirement account is not an IRA but a 401(k) account? No. IRAs, 401(k)s, 403(b)s and most other retirement accounts are similarly protected from creditors and bankruptcy trustees.

Now let’s assume that you didn’t build up that IRA at all — your wife did. She contributed all during her work life, and then she tragically died before she could benefit from the retirement account. She named you as beneficiary, and you “rolled over” her IRA (it could have been a 401(k) or 403(b) — the same rules apply) into a new IRA in your own name. You are now treated as the owner of the roll-over IRA, and it is still exempt from creditors — even though it was inherited.

You can probably see where this is going next. The situation in the Supreme Court case was the next step: Heidi Heffron-Clark’s mother Ruth Heffron was the one who actually built up the IRA. When she died, she named her daughter as beneficiary. Ms. Heffron-Clark was required to begin withdrawing the inherited IRA on a regular schedule, but she chose to leave everything she could in the IRA to continue to earn money tax-free. Then she got into financial trouble, and filed for bankruptcy. The trustee in her bankruptcy proceeding asked the bankruptcy court to order transfer of the IRA to him; he intended to liquidate the IRA and use it to pay Ms. Heffron-Clark’s creditors. She objected that IRAs are exempt from creditors’ claims and bankruptcy, but the court allowed the trustee to gain access.

Ms. Heffron-Clark asked the Federal District Court to overrule the bankruptcy court, and it did. Then the Court of Appeals reversed that finding, ruling that the bankruptcy court (and the bankruptcy trustee) had been right all along. The Supreme Court agreed to review the case, partly because another Court of Appeals from a different Circuit had ruled that an inherited IRA was safe from the bankruptcy trustee. It was important to have a single answer applicable in all U.S. bankruptcy courts.

The Supreme Court agreed that Ms. Heffron-Clark’s inherited IRA had to be paid over to the bankruptcy trustee, and used to pay off some of her debts in bankruptcy. The federal bankruptcy law’s exemption of “retirement funds” did not apply to inherited IRAs, according to the Court, because they were not anyone’s retirement savings — though they were before the original owner’s death.

Now suppose that Ruth Heffron had wanted to preserve her IRA for her daughter, knew that her daughter’s financial health was precarious, and knew that she would likely not live long enough to use the entire retirement account herself. Was there anything she might have done to avoid the result announced in last week’s Supreme Court decision? Yes, as it happens — Ms. Heffron could have simply named a trust for the benefit of her daughter as beneficiary of the IRA (rather than naming her daughter directly), and included appropriate limitations in the trust to protect it from her daughter’s creditors. We have often advocated for creating trusts for inheritances generally, and the Clark v. Rameker decision makes that idea much more compelling, especially for large retirement accounts.

Why would the result be different? Not because there is anything special about retirement accounts, but because it is relatively easy to protect inheritances from the recipient’s creditors by leaving the inheritance in trust — and that same principle applies to retirement accounts. The trust itself is slightly more challenging to create, but worth the effort in many, perhaps most, cases.

First we have to clarify a couple of often-misunderstood concepts. We will write here about IRAs, but the same rules will apply to pretty much any “qualified” retirement plan. That means 401(k), 403(b), Keogh, SIMPLE, SEP-IRA and other plans will follow the same rules. Different tax rules apply to Roth accounts, but some of the same distribution principles will apply. For convenience, though, we will keep talking about IRAs.

There are actually several stages of IRA we might discuss. Let’s distinguish among them:

A regular IRA is “owned” by the contributor. There may be some community property rules in the state in which the contributor resides, or some marital rights attaching to the IRA in non-community property states, but for tax purposes the contributor “owns” the IRA.

One choice your beneficiary may have after your death is to “roll over” your IRA. If your beneficiary is your spouse, he or she can roll the IRA over into a new IRA in their name. This, incidentally, is where the IRA/401(k) (and etc.) distinction gets muddy; your spouse can roll your 401(k) account over into a new IRA. Those IRAs, whatever their source, are usually referred to as “roll-over” IRAs.

Spouses are not the only ones who can roll IRAs into a new account. Non-spouse beneficiaries can also do something similar, and the resulting accounts are often called “roll-over” IRAs, too. But they are different. They are also “inherited” IRAs (see below), and the beneficiary must begin withdrawing money from an inherited IRA immediately.

If a non-spouse beneficiary leaves your IRA right where it is, they become the owner but the IRA is now an “inherited” IRA. They can designate a beneficiary in case they die before withdrawing all the IRA funds, but any beneficiary will have to make withdrawals at your beneficiary’s rate. So, in other words, you name your 45-year-old daughter as beneficiary, you die, she names her 22-year-old son as her beneficiary, and upon her death he has to withdraw based on her actuarial life expectancy, not his own. She might have decided to move your IRA to another custodian; in that case she has an IRA that is both a “roll-over” and an “inherited” IRA.

With that background, the Internal Revenue Service has recently clarified how this all can work if you name a trust as beneficiary of your IRA. In Private Letter Ruling 201038019, issued on September 24, 2010, the IRA gave guidance to an individual taxpayer who requested approval for a proposed way of handling just this problem.

Private Letter Rulings, by way of background, are not intended to be official regulations or rules. They are individual guidance offered (for a substantial fee) to individual taxpayers who want to be sure they are not going to get in trouble. Although “private” in the sense that they apply only to that taxpayer, they are public in the sense that the IRS discloses them to everyone, and they do give some indication of how the IRS thinks about the issues addressed. You are probably safe proceeding on the basis of an Private Letter Ruling.

Here’s what the taxpayer proposed to do, and what the IRS approved, in the recent Private Letter Ruling:

The decedent had named his revocable living trust as beneficiary of two IRAs. He had three children, each of whom was to receive an equal share of the trust after his death.

The trustees of his trust proposed to divide each of the IRAs into three separate IRAs. In other words, there would be a total of six IRAs, still (for the moment) in the name of the decedent. Then each child would be named as beneficiary of two of the IRAs — one from each of the original IRAs.

Once that was accomplished, each of the six “transitional” (their term) IRAs would be rolled over into a new IRA. Each of those new IRAs would name one of the children as the inherited owner, and each child could then name his or her own IRA beneficiaries.

The custodians of those “final” six IRAs were each given a copy of the decedent’s revocable living trust, which was valid under state law and became irrevocable upon the decedent’s death. Those elements of the plan critical because they are required by federal tax law.

Each of the three children would be required to begin withdrawing their IRAs immediately, and at the rate calculated for the oldest of the three children.

The taxpayer’s proposed approach was fine with the IRS, but it would not necessarily be the only way to proceed. The trustee of the trust might be permitted, for instance, to leave the IRAs right where they were, to withdraw the funds over the period of the oldest child’s life expectancy, and to distribute those withdrawn amounts to the three children. But the IRS guidance makes it clear that this approach works, too.

The Private Letter Ruling doesn’t address one question. Why would the original IRA owner have named his trust as beneficiary if the IRAs were going to be distributed outright to the three children anyway? In such a case, we usually recommend that the owner name his children as beneficiaries directly — thereby avoiding the shortened payout period based on the oldest child’s life expectancy, as well as the need to go through the intermediate steps described in the Private Letter Ruling.

There are a number of reasons the IRA owner might have chosen to leave his IRAs to his trust. Usually those reasons include a disabled spouse, a child receiving public benefits, an unequal distribution of proceeds or some other complication. The Private Letter Ruling in this case does not give us enough information to determine which, if any, of those conditions applied. Still, it does give us valuable guidance for those cases in which a trust is named as beneficiary of an IRA.